Second Department Affirms Invalidation of Promissory Note From Sponsor-Controlled Board of Managers to the Sponsor of a Residential Condominium Conversion Plan

Posted onSeptember 19, 2012|Comments Off on Second Department Affirms Invalidation of Promissory Note From Sponsor-Controlled Board of Managers to the Sponsor of a Residential Condominium Conversion Plan

(Victor M. Metsch is a Senior Litigation/ADR partner at Hartman & Craven LLP. He can be reached at vmetsch@hartmancraven.com. He maintains a website at www.LegalVictor.net and can be found on Twitter at @LegalVictor1).

On August 22, 2012, the Second Department issued a clear and concise Decision and Order in Board of Managers of Marbury Club Condominium v. Marbury Corners, LLC, 2012 NY Slip Op. 06008.

The first paragraph described the appeal:

In an action, inter alia, for a judgment declaring that a certain promissory note and related documents are illegal, invalid, and/or otherwise unenforceable, the defendants appeal, as limited by their brief, from so much of an order and judgment (one paper) of the Supreme Court, Westchester County (Scheinkman, J.), dated September 22, 2010, as granted those branches of the plaintiff’s motion which were for summary judgment declaring that the subject promissory note and related documents are illegal, invalid, and/or otherwise unenforceable and on the cause of action for injunctive relief, declared that the subject promissory note and related documents are illegal, invalid, and/or otherwise unenforceable, and awarded the plaintiff certain injunctive relief.

The summary disposition by the Appellate Division does not describe the “backstory” set forth, in extraordinary detail, in the September 22, 2010 Decision, Order and Judgment of the Supreme Court, Westchester County (Alan D. Scheinkman, J.) [28 Misc.3d 1240A; 2010 NY Slip Op 51650U).

Justice Scheinkman meticulously described legal dispute:

Plaintiff is the current Board of Managers, elected by the Unit Owners, of the Marbury Club Condominium, a 55-unit residential condominium created pursuant to Article 9-B of the Real Property Law, located in Pelham, New York (the “Condominium”). Units in the Condominium were offered for sale and sold pursuant to an Offering Plan accepted for filing with the New York Secretary of State on March 30, 2004 and declared effective in January 2005. Defendant MC LLC was the Sponsor of the Offering Plan.

This action arises from a promissory note dated April 14, 2005 in the amount of $2,200,000.00 made by the condominium in favor of the Sponsor, MC LLC (the “Promissory Note”)…To secure payment on the Promissory Note, MC LLC received (1) an assignment of common charges dated April 14, 2005 from the Marbury Club Condominium to MC LLC (the “Pledge Agreement”)…(2) a Security Agreement granting MC LLC a security interest in all of the Condominium’s accounts (the “Security Agreement”)…and (3) a UCC-1 Financing Statement with respect to the Security Agreement (the “Financing Statement”) (the Pledge Agreement, Security agreement and Financing statement are collectively referred to as the “Security Documents”).

The Promissory Note and Security Documents were allegedly entered into with the consent of the Board of Managers of Marbury Corners, LLC (the “Sponsor Board”), consisting of the individual defendants Martin Ginsburg, William Riehl, Susan Newman, Dan Mulvey and Rob Lodes. The Promissory Note and Security Documents have since been assigned to an affiliated company of MC LLC’s, Defendant Holdings LLC, pursuant to various assignments dated April 1, 2009.

It is undisputed that the Promissory Note was fully disclosed in the Offering Plan. In the section entitled “SPECIAL RISKS”, it is stated that “[u]pon the conveyance of title to the first Unit, the Condominium will execute and deliver to the Sponsor a Promissory Note in the amount of $2,200,000” and it further disclosed that “the note would be for a term of 40 years, payable interest only at a rate of 4.5% for the first five years, payable thereafter at the interest rate of 5.5% with the principal to be amortized over a 35-year period; and secured by a pledge of the Condominium’s rights and interests to common charges, a security agreement and UCC-1 financing statements…”

Supreme Court summarized the procedural history of the action:

This action was initiated by Plaintiff’s filing of the Summons and Complaint on December 17, 2009… On March 2, 2009, Defendants filed their answer which asserted affirmative defenses and Defendant MC LLC interposed a counterclaim to recover its reasonable attorneys’ fees incurred in connection with this lawsuit.

Plaintiff’s First Cause of Action seeks a declaratory judgment declaring that the Sponsor Appointed Managers had no “legal right, power or authority to authorize, direct and/or permit Ginsburg to execute and deliver the [Promissory] Note [and Security] Documents to MC LLC” and that the Promissory Note and Security Documents “are illegal, invalid and/or otherwise unenforceable”… The Second Cause of Action seeks an injunction against the continued payments on the Promissory Note because the Condominium’s viability, credit and finances threaten to be irreparably harmed and also seeks an order requiring that the Promissory Note and Security Documents be cancelled, surrendered and returned to Plaintiff and that all liens be released and discharged. The Third Cause of Action seeks compensatory damages in the form of a return of the interest and principal paid on the Promissory Note…

Justice Scheinkman then described the facts based upon the affidavit of Martin Ginsburg, a principal of the Sponsor:

Ginsburg avers that he was involved in obtaining the municipal approvals for the construction of the Condominium and in preparing the Offering Plan. He reviews the disclosure found in the Offering Plan concerning the transaction, as indicated by Plaintiff in its moving papers, and further attaches the budget for the Condominium which was made part of the Offering Plan. The budget “specifically included a line item for debt service of the Note and one of the Footnotes to the Budget…explained the terms of the Note and the documents to be executed in connection therewith”…He further points out that each unit owner had to indicate his/her willingness and consent to accept title to his other unit subject to the terms of the Offering Plan…

To support the position that the Promissory Note was supported by consideration, Ginsburg explains that ordinarily condominiums are taxed pursuant to RPL … 339-y as though they are rental buildings with valuations based on assumed rental income, thereby resulting in assessed valuations lower than the assessed valuations that would apply to comparable single-family homes. Ginsburg states that the Village of Pelham adopted the Homestead Tax Option under Section 1903 of the New York Real Property Tax Law (“RPTL”) and, under this legislation, the units in the Condominium were going to be taxed at full market value and “the sales price of each unit would function as the basis for determining the market value of that unit for tax assessment purposes”…Ginsburg avers that this situation was explained in the Offering Plan and in a tax opinion by the Albert Valuation Group…which was submitted with the Offering Plan to the Attorney General’s office.

According to Ginsburg, when he received the estimate of the real estate taxes, it was so “astonishingly high” that “the Sponsor withdrew the then pending Offering Plan for the Condominium and…prepared and submitted to the Attorney General’s office an offering plan for cooperative ownership” because a cooperative ownership would allow the building to be treated as a rental building for tax purposes and avoid the “harsh” tax consequences of the Homestead Tax Option…

But, Ginsburg says, when the Village of Pelham got wind of the contemplated change from condominium to cooperative ownership, and the consequent lowering of the prospective tax revenues from the project, the Village threatened to rescind its approvals if the Sponsor moved forward with its plan to change to cooperative ownership. To avoid a fight with the Village and risk delays in construction and completion of the building, the Sponsor reverted to its condominium pan. But, as Ginsburg expressly admits, this meant that the Sponsor would reduce the sales prices on which the assessed valuations would be based. Ginsburg explains this as a means to lower the tax burden on the Unit Owners. In reality, this was undoubtedly an effort to make the units more marketable.

While the Sponsor was willing to lower the sales price, it was not willing to forego the loss of the sales revenue. After exploring various options for recouping the lost sales revenue (such as a flip tax and making the garage a separate condominium unit that the Sponsor would keep and lease to the Condominium), the Sponsor decided to take back the $2.2 million Promissory Note and, further, to require Unit Owners to lease at least one parking space in the garage to the Condominium and use the rent to pay the debt service on the Note. Additionally, the Condominium was to receive a fee for the use of its recreational facilities by a separate condominium also being developed by the Sponsor…

As support that this was the purpose behind the Promissory Note, Ginsburg attaches correspondence during this time frame which shows how this idea evolved…

Ginsburg claims that these facts were fully disclosed in the budget and the footnote to the budget in the Offering Plan, which made clear that the annual revenue from both would be over $112,000 a year — enough to cover the debt service on the Promissory Note…He avers that this information could not have been included in the Offering Plan because the information would then have been used by the Village of Pelham to include the amount of the Note in determining the assessed values of the units, which would have defeated the purpose behind the Promissory Note…

As to the Board of Managers contentions with respect to RPL § 339-jj, Supreme Court wrote:

Plaintiff’s President … argues that the net effect of the Promissory Note and Security Documents is that defendants placed “an illegal mortgage on the property [and] asserts the Promissory Note and Security Documents are illegal because “[t]he only authority for a board of managers of a condominium to borrow money and incur debt, including the authority to assign common charges to secure such borrowing, is derived from Section 339-jj of the Real Property Law (RPLR 339-jj)” and “[u]nder RPL 339-jj, a condominium board of managers has authority to borrow on behalf of a condominium only where either the condominium declaration or by-laws expressly provide that such borrowing power exists or, beginning five years after the conveyance of a condominium unit, for certain statutorily-enumerated purposes”…

* * *

It is Plaintiff’s position that the legislative history behind RPL § 339-jj shows that it was intended to limit the authority of a Condominium Board to borrow money secured by the assets of the Condominium and the statute does not permit the Sponsor Board “to authorize the Promissory Note secured by an assignment of common charges at any time, much less a time when it was under sponsor control” (id).

And, as to the Sponsor’s response, Justice Scheinkman wrote:

Defendants argue that RPL § 339-jj was never intended to apply to a situation such as this one where the Promissory Note and Security Documents were fully disclosed and each unit owner consented to the Promissory Note and Security Documents when they signed the purchase agreement. Indeed, Defendants argue that such application would be contrary to the legislative history since its purpose was described as providing “assistance to condominiums by allowing a board of managers to borrow for capital purposes subject to safeguards for the protection of the affected unit owners” and that by vesting such power in the Board of Managers by allowing the unit owners to limit or prohibit the board’s authority to borrow in the declaration of the condominium, owners would be protected from “improvident borrowing”…Defendants also point to the Bill’s Sponsor’s description of the Bill’s purpose as providing statutory authority for condominiums to borrow for capital purposes from institutional lenders (thereby encouraging lenders to lend) while protecting unit owners by allowing them to prohibit borrowing in the condominium documents…Defendants argue that it is evident that the legislation was intended to address circumstances that do not exist in this case since the Unit Owners each consented to the debt before purchasing their units.

Supreme Court found the promissory notes and security documents to be in violation of RPL § 339-jj and unenforceable on the facts:

In this circumstance, the Sponsor caused the Condominium to incur $2.2 million in debt so that the Sponsor could recoup the sales proceeds that the Sponsor lost as a result of the Sponsor’s decision to reduce the sales price of the units in order to lower the tax assessments for the units. Put another way, the Unit Owners were required to pay additional consideration for their purchase of their units through a compelled indirect financing mechanism under which the Sponsor would get more money for selling the units through a purported parking lease. Not only is a borrowing by the Condominium for the purpose of financing the acquisition of units, or for the purpose of creating an artificially low sales price for real estate tax purpose, not a borrowing within the scope permitted by the statute, but the borrowing occurred within the first five years of the Condominium.

The Court does not accept Defendants’ argument that the Unit Owners benefitted from the reduction in sales price; the reduction was entirely illusory in that it was going to be recouped, at least to a significant extent, by the Sponsor’s requirement that each Unit Owner lease a parking space and that the revenues generated by these leases be used to pay off the Promissory Note. Indeed, the decision to initially reduce the sales price and then make up for the reduction with the Promissory Note was entirely premised on the need for the Sponsor to recoup the profits it lost upon its decision to reduce the basis on which the units would be taxed. The Sponsor chose this route so as to avoid having to follow the legitimate (but more difficult) route of changing to a cooperative plan and obtaining all new approvals. While the Court appreciates the Sponsor’s bluntness, it cannot turn a blind eye to it. Moreover, if the Sponsor had simply reduced the sales price and left it at that, the unit Owners would have benefitted from the lower prices (and the truly appropriate lower taxes) but the Sponsor would have lost profits. Borrowing by the Condominium in order to line the Sponsor’s pockets is simply not within the scope of the limited purposes allowed by RPL § 339-jj and certainly not within the contemplation of the legislative drafters, sponsors and advocates.

To the contrary, it appears that the present situation involves an effort by a Sponsor to “hide a sin”, as was feared by some at the time the legislation was being considered. While the fact of the borrowing was disclosed, the purpose of the borrowing was not. Nowhere were purchasers informed that the borrowing plan was devised as a means by which the Sponsor could recoup the profits lost by purchase price reductions made in order to artificially achieve lower realty taxes. Putting it another way, the unit purchasers were not informed that they were being required to pay rent for parking spaces, which parking was originally intended to be free of charge, so that the Sponsor could receive more money on account of its sale of the units. Nor were they informed of any risks that the Village might seek to increase their taxes if it found out that the sales price had been reduced by this stratagem.

and the law –

“[C]ontracts which violate statutory provisions are, as a general rule, unenforceable on public policy grounds where the statute which is violated is enacted to protect the public health and safety…or where the statute’s purpose [is] the protection of public…morals or the prevention of fraud”…Thus, “a party to an illegal contract cannot ask a court of law to help him carry out is illegal object…No one shall be permitted to profit by his own fraud…or to found any claim upon his own inequity”…

* * *

Here, it is clear that RPL § 339-jj was enacted to protect condominium unit owners from unscrupulous sponsors by ensuring that they have a say in the condominium’s borrowing by requiring that the authority of the condominium board to borrow be set forth in the Declaration or By-Laws, by requiring that any such borrowing be delayed for a period of five years, and that it be approved by a majority of the Unit Owners.

And focusing on the sponsor’s conduct, Justice Scheinkman concluded that:

The improper purpose behind the Promissory Note and the Security Documents is not lost on this Court and if this Court were to enforce the Promissory Note and Security Documents under such circumstances, it would run counter to the public policies underlying RPL § 339-jj and as well as generally equitable principles.

Accordingly, because RPL §§ 339-jj was enacted to encourage borrowing to fund capital projects while at the same time protect unit owners from borrowing undertaken by Sponsor-dominated boards who were not given express authority to borrow in the Declaration or By-Laws, the Court shall not enforce the Promissory Note and Security Documents and shall declare the Promissory Note and Security Documents void as violative of RPL §§ 339-jj…

The Decision and Order of the Second Department adopted, as “correctly determined”, Supreme Court’s conclusion “that the subject promissory note was made in violation of Real Property Law § 339-jj(1)…and that, under the circumstances of this case, the promissory note and related documents are unenforceable[.]”

The brevity of the affirmance by the Appellate Division belied the unusual factual scenario confronted by the Supreme Court; the conflicting legal positions presented by the parties; and the careful analysis that led Justice Scheinkman to declare the $2.2 million “void as violative of RPL § 339-jj[.]”.

Victor M. Metsch and Michael Regan of Hartman & Craven LLP represented the plaintiff-condominium before both Justice Scheinkman and the Appellate Division.

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